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Hedge funds promise downside protection — and risks

  • Because hedge funds use strategies that differ from long-only equity investing, they produce results quite different from what the market dishes out.
  • But fees are high — really high — and hedge funds are complicated.
  • Liquidity is also a concern.
A whole host of drawbacks might make you think twice about hedge funds.
Yellow Dog Productions | Getty Images
A whole host of drawbacks might make you think twice about hedge funds.

Though hedge funds often signal a freewheeling, shoot-from-the-hip investment style, for the most part these investment vehicles aim to dampen volatility. They do it by using various strategies that are supposed to provide protection from market volatility and sometimes even positive returns during market declines.

"Someone who is concerned about the downside may want to allocate to hedge funds in case there is a big meltdown in the markets," said Tayfun Icten, an analyst with research firm Morningstar, who follows hedge funds.

But along with that important positive come a whole host of drawbacks. Which might make you think twice about hedge funds.

It also should be noted that the Securities and Exchange Commission requires individuals to qualify as accredited investors to use hedge funds. At a minimum, they must have annual income of $200,000 and net worth above $1 million.

Pro: Potential downside protection

The appeal of downside protection can't be denied. Because hedge funds use strategies that differ drastically from long-only equity investing, they produce results that are quite different from what the market dishes out. In 2008, for example, the Standard & Poor's 500 lost 38 percent of its value and the Dow Jones fell by 34 percent, but the average hedge was down by only 18 percent. Including hedge funds in a year like that could buoy portfolios and produce above-average results.

"They offer a unique return source than what you get from growth and value stocks," Icten explained.

How do they do it?

There are a number of strategies. One of the most popular is long-short. The long/short strategy is a method of investing that involves taking long positions in stocks that are expected to increase in value and short positions in stocks that are expected to decrease in value

Another popular style is merger arbitrage, which invests in companies that have announced a merger or acquisition. These funds are wagering that the merger will be completed in the time frame spelled out in the original announcement and at the price agreed to by management. But a lot can go wrong until the final deal is completed.

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"You get paid for taking on the risk that the deal may not close," Icten said. "There are risks that come up around antitrust issues that may derail the deal or that the [Department of Justice] might stop the deal from completing.

"Those risks are totally different than what you get in the stock market."

Recently, activist funds have overtaken others as the most popular of hedge fund strategies, reports eVestment, a research firm that compiles data on the hedge fund industry. These funds buy up large ownership stakes of companies and then try to influence management to cut costs and approve larger dividend- and share-buyback programs, all in the interest of increasing the companies' share prices.

Because of the low correlations between hedge funds and other investments, Carol Schleif, deputy chief investment officer of Wells Fargo's high-net-worth unit, Abbot Downing, recommends a 10 percent to 40 percent allocation to hedge funds for Abbot Downing's clients with a moderate risk tolerance.

"You would want a higher allocation in a moderate portfolio than an aggressive portfolio, because you're trying to smooth out day-to-day volatility," she said.

Con: Fees are high — really high

But for some investment advisors, hedge funds' many downsides prevent them from taking advantage of their positives. Fees are the biggest concern, as they can run as high as 2 percent of assets under management, plus 20 percent of profits. Consider that mutual fund fees have been coming down over the last decade, and it's possible to build a diversified portfolio of low-cost funds for under 1 percent.

"That's a big hurdle, and you have to provide a massive amount of value to do that," said Zack Shepard, vice president of Matson Money.

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To add insult to injury, hedge fund performance has trailed that of equities for several years. In 2017 the average hedge fund has vastly underperformed the S&P 500, according to eVestment.

"Some funds haven't done well relative to a long-only market," Schleif said. "But you wouldn't expect them to; they're using other strategies."

Con: Liquidity is a concern

Hedge funds also make it tricky for investors to easily get their money back so that portfolio managers can avoid having to sell securities at a loss when they are investing in illiquid markets. So they have several ways to limit how frequently investors can redeem their shares. First, there's a lockup period, the initial period after an investor first gets into the fund.

Then, hedge funds allow redemptions only a few times a year, and only after notification several months in advance, possibly locking up your money for six months at a time.

"If investors want to dampen volatility, then they should own short-term, high-quality fixed income." -Zack Shepard, vice president of Matson Money

"I don't know why anyone would want to include a liquidity issue into their portfolio," said Shepard of Matson Money.

What's more, some hedge funds might restrict redemptions during times of extreme market volatility, just when you might need your money.

Con: They're too complicated

While hedge funds may have the allure of protecting investor's money on the downside, for many financial advisors, that protection comes at too high a cost, both in terms of fees and liquidity risk.

Many advisors believe it's possible to achieve the same effect by structuring a portfolio to withstand market declines. The key is to stay disciplined even as markets plummet.

"If investors want to dampen volatility, then they should own short-term, high-quality fixed income," Shepard said. "It dampens the equity risk, and it's liquid and not high-cost."

In addition, liquid alternatives funds employ some of the same strategies that hedge funds do, but available under the 40 Act structure, named after the act of Congress that established mutual funds in 1940.

Liquid alts, a broad category, includes strategies such as managed future, market neutral, multicurrency, multi-asset and long/short equity. Though their fees are higher than other mutual funds, they are much lower than hedge funds. And you can avoid some of the liquidity issues and high-minimum requirements.

— By Ilana Polyak, special to CNBC.com

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